After all the debate in recent weeks over issues related to raising the nation's debt limit, it's hard to know exactly what might happen after August 2. Borrowing represents more than 40% of the nation's expenses, and any default on the country's obligations would be unprecedented.
As a rule, panic generally doesn't help you make wise financial decisions. That's why now might be a good time to review your portfolio to see if you have more exposure to a particular asset class than you'd prefer, regardless of what happens in Washington. And as the situation evolves, here are some mileposts that bear watching:
Auctions of Treasury securitiesThe yield on the 10-year Treasury note can serve as a barometer of anxiety levels; the higher the yield goes, the more bond prices will fall, indicating increasing anxiety in the bond markets.
Regardless of whether the debt ceiling stays the same, several significant auctions of Treasury securities are scheduled shortly after the August 2 deadline. Bids for 3- and 10-year notes and 30-year bonds will begin on August 3, and auctions will take place August 9-11. More importantly, the nonprofit Bipartisan Policy Center (BPC) estimates that payment of roughly $90 billion on maturing Treasury securities is due on August 4.
The difficulty in producing an agreement to raise the limit has led two major credit rating agencies to announce they are officially reviewing the United States' historically impeccable credit rating. Even if the Treasury attempts to avoid defaulting on Treasury securities by prioritizing payment of its obligations, the rating agencies have warned that any such move would likely trigger a downgrade, especially if no consensus has been reached on how to tackle the deficit.
A lowered credit rating would mean the United States would have to pay more to borrow in the future, making the national debt problem even worse in the long term. That's because the greater uncertainty about the country's willingness and ability to pay its bills would likely lead both domestic and foreign investors to demand greater compensation for buying Treasuries.
Bonds and non-Treasury borrowingHigher interest rates for Treasury bonds might also result in higher interest rates on other, nongovernmental loans such as mortgages and consumer credit. Since many interest rates are based on Treasury rates, rates generally would likely be affected. And since bond prices fall when rates rise, you should keep an eye on your bond portfolio.
One indicator of investors' assessment of the risks of Treasury bonds compared to other debt is what's known as the Baa/Treasury spread, which measures the difference between the yields of corporate bonds rated Baa and 10-year Treasuries. Normally, investors demand a higher yield for corporates because of their greater risk of default. The narrower the gap between the two, the less risky investors feel corporate bonds are compared to Treasuries.
Higher rates also could mean reduced credit availability. Some observers worry that tighter credit on top of a weak housing market could hamper economic recovery. And even if there were technically no default, the mere absence of an agreement that addresses the issue before August 2 would likely raise the global anxiety level substantially.
EquitiesThe stock market hates uncertainty, and the greater the uncertainty, the greater the potential impact on stocks. If investors become concerned about the availability of credit, they could punish companies that rely heavily on it. Fortunately, in the wake of the 2008 financial crisis, many companies took advantage of low interest rates to issue new bonds and/or refinance older debt. Also, many companies, fearing a sequel to 2008, have been sitting on a larger amount of cash than usual, which could help cushion the impact of tighter credit.
Markets also will be assessing the impact of either severe budgetary cutbacks or prioritization of existing government bills on the already fragile economy as a whole. If either seems to pose a serious threat to consumer spending, equities could feel the fallout.
Payment of government benefits, contracts, and departmentsAccording to the BPC, the country will have roughly $172.4 billion coming in during the rest of August to pay $306.7 billion of scheduled expenditures. Without an increase in the borrowing limit, the Treasury will have to rely on those revenues and prioritize which of its existing bills to pay. Here are some of the major payments scheduled for shortly after the Treasury's August 2 deadline:
Social Security payments for beneficiaries who began receiving benefits before May 1997 or who receive both benefits and Supplemental Security Income (SSI) are scheduled for August 3. Benefits for recipients with birth dates between August 1-10 are scheduled for the following Wednesday, August 10. Those with birth dates between the 11th and the 20th are scheduled for August 17, and August 24 is the date for birthdays between the 21st and the 31st.
For military service members, August 15 is the date for the scheduled mid-month installment of active duty pay, with the associated "advice of pay" notice set for August 5. And as previously noted, an estimated $90 billion in Treasury debt payments are due August 4.
Medicare, Medicaid, Social Security benefits, defense vendor payments, interest on Treasury securities, and unemployment insurance represent some of the federal government's largest costs for the month. The BPC estimates that covering those costs completely would leave no funds for such obligations as the Departments of Education, Labor, Justice, and Energy; federal salaries and benefits; military active duty pay and veterans' affairs; the Federal Transit Administration, Federal Highway Administration, Small Business Administration, and the Environmental Protection Agency; Housing and Urban Development and federal food and nutrition services; and IRS refunds.
The outlook for an agreementPlans have been put forward to tie increases in the debt ceiling to a balanced budget constitutional amendment, to specific spending cuts, and to a combination of spending cuts and revenue increases. There also has been talk of a fail-safe plan that would give the president authority to increase the debt ceiling in stages before the 2012 election; Congress would be able to vote against those increases but would not be able to effectively prevent them.
One proposal that seems to have a chance of winning at least some bipartisan support is based on months of negotiations by the "Gang of Six" senators from both parties. The proposal is designed to cut an estimated $3.7 trillion from the deficit over 10 years through such measures as shrinking the current six tax brackets to three, eliminating the alternative minimum tax, revising how Social Security cost-of-living increases are calculated, and reducing tax deductions for such items as mortgage interest, charitable donations, and retirement savings.
All parties have agreed it's important not to jeopardize the country's financial health. As the road to a resolution unwinds, it can be helpful to keep calm and monitor the situation.
All investing involves risk, including the risk of loss of principal, and there can be no guarantee that any investment strategy will be successful.
Wednesday, July 27, 2011
Wednesday, July 13, 2011
Discipline: Your Secret Weapon
Working with markets, understanding risk and return, diversifying and portfolio structure—we've heard the lessons of sound investing over and over. But so often the most important factor between success and failure is ourselves.
The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.
What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.
This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.(1)
The survey found 40 per cent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.
"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."
This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.
In a speech in Sydney(2), Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.
"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."
Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.
These behavioural issues and how they impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.(3)
Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behaviour has been shown to be more prevalent in men than in women.
A study quoted in The Wall Street Journal(4) showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.
The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behaviour by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualised returns of just 3.8 per cent, well below the 9.1 per cent delivered by the market index, the S&P 500.(5)
What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.
So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.
An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.
Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.
1. 'Risk and Rules: The Role of Control in Financial Decision Making', Barclays Wealth, June 2011
2. 'Far Too Much Economic News for Our Own Good', Ross Gittins, Sydney Morning Herald, June 13, 2011
3. Barberis, Nicholas and Thaler, Richard, 'A Survey of Behavioral Finance', University of Chicago
4. 'For Mother's Day, Give Her the Reins to the Portfolio', Wall Street Journal, May 9, 2009
5. '2011 QAIB', Dalbar Inc, March 2011
The recent rocky period in financial markets has brought to the surface some familiar emotions for many, including a strong urge to try to time the market. The temptation, as always, is to sell into falling markets and buy into rising ones.
What's more, the most seemingly "well-informed" people—the kind who religiously read the financial press and watch business television—are the ones who feel most compelled to try and finesse their exit and entry points.
This suspicion that "sophisticated" investors are the most prone to try and outwit the market was given validity recently by a study, carried out by London-based Ledbury Research, of more than 2,000 affluent people around the world.(1)
The survey found 40 per cent of those questioned admitted to practising market timing rather than pursuing a buy-and-hold strategy. Yet the market timers were more than three times more likely to believe they traded too much.
"On the face of it, you might think that those who were trading more actively would be more experienced, sophisticated and able to control themselves," the authors said. "But that seems not to be the case—trading becomes addictive."
This perspective has been reinforced recently by one of the world's most respected policymakers and astute observers of markets—Ian Macfarlane, the former governor of the Reserve Bank of Australia and now a director of ANZ Banking Group.
In a speech in Sydney(2), Macfarlane made the point that the worst investors tend to be those who follow markets and the financial media fanatically, extrapolating from short-term movements big picture narratives that fit their predispositions.
"Most people experience loss aversion," he said. "They experience more unhappiness from losing $100 than they gain in happiness from acquiring $100. So the more often they are made aware of a loss, the unhappier they become."
Because of this combination of hyper-activity, lack of self-control and loss-aversion, investors end up making bad investment decisions, Macfarlane noted.
These behavioural issues and how they impact on investors are well documented by financial theorists. Commonly cited traits include lack of diversification, excessive trading, an obstinate reluctance to sell losers and buying on past performance.(3)
Mostly, these traits stem from over-confidence. Just as we all tend to think we are above-average in terms of driving ability, we also tend to over-rate our capacity for beating the market. What's more, this ego-driven behaviour has been shown to be more prevalent in men than in women.
A study quoted in The Wall Street Journal(4) showed women are less afflicted than men by over-confidence and are more likely to attribute success in investment to factors outside themselves – like luck or fate. As a result, they are more inclined to exercise self-discipline and to avoid trying to time the market.
The virtues of investment discipline and the folly of 'alpha'-chasing are highlighted year after year in the survey of investor behaviour by research group Dalbar. The latest edition showed in the 20 years to the end of December 2010, the average US stock investor received annualised returns of just 3.8 per cent, well below the 9.1 per cent delivered by the market index, the S&P 500.(5)
What often stops investors getting returns that are there for the taking are their very own actions—lack of diversification, compulsive trading, buying high, selling low, going by hunches and responding to media and market noise.
So how do we get our egos and emotions out of the investment process? One answer is to distance ourselves from the daily noise by appointing a financial advisor to help stop us doing things against our own long-term interests.
An advisor begins with the understanding that there are things we can't control (like the ups and downs in the markets) and things we can. Some of the things we can control including ensuring our investments are properly diversified—both within and across asset classes—ensuring our portfolios are regularly rebalanced to meet our long-term requirements, keeping costs to a minimum and being mindful of taxes.
Most of all, an advisor helps us all by encouraging the exercise of discipline—the secret weapon in building long-term wealth.
1. 'Risk and Rules: The Role of Control in Financial Decision Making', Barclays Wealth, June 2011
2. 'Far Too Much Economic News for Our Own Good', Ross Gittins, Sydney Morning Herald, June 13, 2011
3. Barberis, Nicholas and Thaler, Richard, 'A Survey of Behavioral Finance', University of Chicago
4. 'For Mother's Day, Give Her the Reins to the Portfolio', Wall Street Journal, May 9, 2009
5. '2011 QAIB', Dalbar Inc, March 2011
Wednesday, July 6, 2011
Stars or Straws?
Investors frequently seek external validation to ease the anxiety of putting their money at risk. Problem is there is no guarantee that a "five-star" rating on a chosen fund will lead to a "five-star" investment experience.
It is human nature for consumers to seek comfort in the idea that the products they are buying are proven in the marketplace. That need is met by ratings agencies that play a legitimate and vital role in providing independent assessments of various investment products.
Those assessments are made in professionally compiled and detailed reports that can be a useful yardstick for investors and their advisors in comparing funds so that they can make a fully informed decision.
But despite diligent cautions from the agencies about chasing returns, problems arise when consumers blindly extrapolate star rating systems for various funds into imagined future performance.
The risks of this approach were highlighted in a survey by US private wealth management business Burns Advisory Group, which went back to 1999 to study the subsequent 10-year performance of Morningstar's five-star funds.(1)
Burns found that of the 248 funds rated five-star by Morningstar on December 31, 1999, only four were still receiving that rating a decade later. Of the original sample, 87 had ceased to exist. Of those still existing, all had been downgraded to an average of just under three stars. Even worse, in all categories except international stocks, the average performance for five-star funds over this 10-year period was worse than the average for all funds.
"These findings imply the star ranking methodology leaves long-term investors in the lurch," Burns concluded. "If nothing else, it demonstrates clearly why investors should not rely on one measure as their sole research tool."
But it is not just unsophisticated investors that are chasing performance. Another recent report suggests that even wealthy individuals and institutional investors can be blind-sided by past returns.
The study by researchers at the European School of Management and Technology, quoted in The Economist magazine, looked at how investors allocated money to hedge funds over 10 years from 1994.(2)
The researchers found that the funds that had performed well in the previous three quarters attracted significantly more money than their competitors. In other words, the supposedly "smart money" was chasing past returns.
Bear in mind, also, that indiscriminately chasing returns can be even more costly with hedge funds, which typically charge management fees of 2% or more, plus 20% of the returns they generate for clients.
Given the large body of academic evidence that it is extremely difficult to predict market returns with any confidence, it should be evident that past returns should not be the foundation for choosing one fund over another.
Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.(3)
So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:
•Are the risks being taken related to return?
•Are those risks targeted in a reliable, consistent way?
•How diversified is the fund?
•Does it make promises it can't keep?
•What is more important - individual judgement or clear processes?
•Are the underlying strategies driven by forecasts?
•Does the fund take account of costs and taxes in its decisions?
•Does the fund manager communicate in a clear and consistent way?
While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.
But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them.
This is a grounded, completely defensible approach. The alternative is that by reaching for the stars, investors are left clutching at straws.
1. McGuigan, Tom and Courtenay, Tim, Star Gazing: Five Star Funds Revisited, Burns Advisory Group, April 2010
2. Buttonwood, Who's the Patsy?, The Economist, May 29, 2010
3. Fama, Eugene F., and Kenneth R. French. 2009. Luck Versus Skill in the Cross Section of Mutual Fund Returns, SSRN
It is human nature for consumers to seek comfort in the idea that the products they are buying are proven in the marketplace. That need is met by ratings agencies that play a legitimate and vital role in providing independent assessments of various investment products.
Those assessments are made in professionally compiled and detailed reports that can be a useful yardstick for investors and their advisors in comparing funds so that they can make a fully informed decision.
But despite diligent cautions from the agencies about chasing returns, problems arise when consumers blindly extrapolate star rating systems for various funds into imagined future performance.
The risks of this approach were highlighted in a survey by US private wealth management business Burns Advisory Group, which went back to 1999 to study the subsequent 10-year performance of Morningstar's five-star funds.(1)
Burns found that of the 248 funds rated five-star by Morningstar on December 31, 1999, only four were still receiving that rating a decade later. Of the original sample, 87 had ceased to exist. Of those still existing, all had been downgraded to an average of just under three stars. Even worse, in all categories except international stocks, the average performance for five-star funds over this 10-year period was worse than the average for all funds.
"These findings imply the star ranking methodology leaves long-term investors in the lurch," Burns concluded. "If nothing else, it demonstrates clearly why investors should not rely on one measure as their sole research tool."
But it is not just unsophisticated investors that are chasing performance. Another recent report suggests that even wealthy individuals and institutional investors can be blind-sided by past returns.
The study by researchers at the European School of Management and Technology, quoted in The Economist magazine, looked at how investors allocated money to hedge funds over 10 years from 1994.(2)
The researchers found that the funds that had performed well in the previous three quarters attracted significantly more money than their competitors. In other words, the supposedly "smart money" was chasing past returns.
Bear in mind, also, that indiscriminately chasing returns can be even more costly with hedge funds, which typically charge management fees of 2% or more, plus 20% of the returns they generate for clients.
Given the large body of academic evidence that it is extremely difficult to predict market returns with any confidence, it should be evident that past returns should not be the foundation for choosing one fund over another.
Leading academics Gene Fama and Ken French, in a recent study of mutual fund performance, showed how hard it is for investors to distinguish skill from pure chance in analysing the returns of individual funds.(3)
So what should an investor and his or her advisor weigh up in making a decision? The key here is to focus on items within their control, such as:
•Are the risks being taken related to return?
•Are those risks targeted in a reliable, consistent way?
•How diversified is the fund?
•Does it make promises it can't keep?
•What is more important - individual judgement or clear processes?
•Are the underlying strategies driven by forecasts?
•Does the fund take account of costs and taxes in its decisions?
•Does the fund manager communicate in a clear and consistent way?
While many of these attributes can lead to good outcomes for investors, they are no guarantee of positive returns every year. Anyone who makes those sorts of promises risks disillusioning those who put their faith in them.
But the above characteristics can give investors comfort that their money is being invested in a consistent, transparent way and that ensures that when the targeted premiums kick in, they are positioned to receive them.
This is a grounded, completely defensible approach. The alternative is that by reaching for the stars, investors are left clutching at straws.
1. McGuigan, Tom and Courtenay, Tim, Star Gazing: Five Star Funds Revisited, Burns Advisory Group, April 2010
2. Buttonwood, Who's the Patsy?, The Economist, May 29, 2010
3. Fama, Eugene F., and Kenneth R. French. 2009. Luck Versus Skill in the Cross Section of Mutual Fund Returns, SSRN
Subscribe to:
Posts (Atom)
